HEIGHTENED MARKET VOLATILITY:

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1 Global Equities Forum INSIGHTS.IDEAS.RESULTS. HEIGHTENED MARKET VOLATILITY: Opportunities for the long-term investor 20 APRIL 2016 AMP CAPITAL GLOBAL EQUITIES FORUM 1

2 This paper explores the key challenges around heightened volatility and subdued investment returns. We discuss the effect of market volatility on equity portfolios and how investors can capitalise on emerging opportunities, particularly across global listed real estate and China s industrial sector. We assert that investors are more likely to capture long-term growth when opportunities are considered through an environmental, social and governance (ESG) lens. 2 AMP CAPITAL GLOBAL EQUITIES FORUM

3 GLOBAL LISTED REAL ESTATE: IS IT THE PLACE TO BE WITH VOLATILITY? JAMES MAYDEW Co-Head of Global Listed Real Estate Investors that are nervous about the current environment of volatility will be looking for defensive-growth opportunities supported by relatively stable dividend streams. Listed real estate is a high-liquidity asset class, meaning that investors can respond to market conditions and capitalise on opportunities quickly, this is particularly relevant in a volatile market. The fundamental attributes of this asset class defensive yield and growth position it to continually deliver during economic instability. GLOBAL LISTED REAL ESTATE CAN BE A LIQUID PROXY FOR DIRECT REAL ESTATE OVER THE LONG-TERM Empirical evidence shows that listed real estate is likely to bring similar long-term diversification benefits to a diversified portfolio as direct real estate since the returns of both listed and unlisted real estate are driven by the same economics of the buildings they own, be it the rent, capitalisation rate or tenant covenants. Despite this, global listed real estate is often measured on its short-term performance. While it s true that over the short-term, listed real estate is likely to behave more like equities; over the longer term, direct real estate and listed real estate prices are highly correlated to each other, but lowly correlated to equities. The correlation moves from around 0.05 after one month, but settles at around 0.85 after five years, proving out they are interchangeable to each other over the long term. Figure 1 depicts how the two asset classes move in concert together but with a lag. The correlation between the five-year annualised returns of US listed real estate with direct US real estate is Figure 1: US REITs versus private real estate funds trailing five-year ( ) annualised return Returns (%) US Real Estate Funds US REITs Source: Green Street Advisors LLC (Dec 2015). Past performance is not a reliable indicator of future performance. AMP CAPITAL GLOBAL EQUITIES FORUM 3

4 REITS OUTPERFORM BROADER EQUITIES IN VOLATILE TIMES Historically, Real Estate Investment Trusts (REITs) have outperformed the broader equity market through times of heightened volatility. There are two main fundamentals behind the strong performance of global listed real estate since the economic crisis. Firstly, REITs tend to have invested in the highest quality real estate in the market in which they are located in. They have tended to acquire the best assets as they have had access to the cheapest cost of capital through cycles the sharemarket. Secondly, since the global financial crisis (GFC), their debt costs and absolute debt exposure has been reduced. This means that they are now in much better financial shape. STRONG DEMAND FOR REAL ESTATE: THE RISE OF SOVEREIGN WEALTH FUNDS Attracted by the diversification benefit and strong return potential on offer in real estate, sovereign wealth funds have acquired a net total of approximately US$89 billion in global direct real estate over the past five years. Reflecting this robust demand, in the US, equity funds (dominated by private equity) have made net acquisitions to the tune of US$30 billion in the past six months, which is a momentous increase from the US$3 billion annual pace over the past five years. WHAT CAN THE LISTED REAL ESTATE MARKET TELL US ABOUT DIRECT REAL ESTATE? Listed real estate can be a predictor of how the direct market will move in the coming months, especially around inflexion points at the turning of cycles. Generally speaking, if a REIT trades at a premium to its Net Asset Value or NAV, the market believes that the underlying real estate assets will appreciate more than what the current market is pricing for that same direct real estate. Currently, listed real estate is trading at a discount to its NAV in a number of key markets. This indicates that in the period ahead real estate valuations across some markets will no longer be driven by further capitalisation rate compression; albeit income growth will still be delivered through rental appreciation and occupancy gains. OPPORTUNITIES IN GLOBAL LISTED REAL ESTATE There is a dispersion of returns across countries and sectors within real estate markets see figures 2 and 3. The dispersion in listed real estate returns creates opportunities for globally nimble, active managers to generate alpha. In today s cycle, we see good opportunity in Continental Europe, supported by low interest rates and improving economic growth. We see strong opportunity in global storage, a fragmented asset class with low cap ex requirements and driving growth from ecommerce advertising and consolidation. We also like Japan, a market where land values continue to appreciate, vacancy rates fall and the central bank is explicitly supporting the sector though asset purchases. Figure 2: Listed real estate dispersion: difference in return between highest and lowest performing country 60 Dispersion in country returns (%) Highest Switzerland +40.7% France -1.8% Canada +10.8% Singapore -27.7% Singapore +65.4% Switzerland +13.8% Japan +31.9% Singapore -10.6% United States +29.0% Japan -14.9% Germany +8.3% Canada -20.2% Lowest Source: Bloomberg, as at 31 December Returns are represented by country indices within the FTSE EPRA / NAREIT Developed Total Return Index suite (Australia, Canada, France, Germany, Hong Kong, Japan, Singapore, UK, Switzerland). Returns are calendar years , expressed in $US. Past performance is not a reliable indicator of future performance. Listed real estate is likely to bring similar long-term diversification benefits to a diversified portfolio as direct real estate. 4 AMP CAPITAL GLOBAL EQUITIES FORUM

5 Figure 3: Listed real estate dispersion: difference in return between highest and lowest performing sector 70 Dispersion in sector returns (%) Highest Lodging/Resorts +40.0% Self Storage +31.4% Industrial +40.6% Lodging/Resorts +27.6% Residential +34.9% Self Storage +40.4% Lowest Industrial +12.7% Diversified -17.6% Residential +12.3% Healthcare -6.9% Diversified +1.4% Lodging/Resorts -22.5% Source: Bloomberg, as at 31 December Returns are expressed in USD and represented by the respective sector indices within the FTSE EPRA / NAREIT Developed Total Return Index suite Returns are calendar years , expressed in $US. Past performance is not a reliable indicator of future performance. MANAGING THE CYCLE REITs have been selling real estate assets into the wall of capital demand for prime real estate. In the markets where they are trading at discounts to NAV s, the best REIT management teams are taking advantage of strong pricing in direct real estate markets, improving their portfolios by selling non-core assets and utilising the proceeds to either de-lever balance sheets or shrink their equity base by returning capital to investors. LEVERAGE POST-GFC Over the next two years we expect the leverage of many global REITs to fall further as they balance the risk of being in the latter stages of a cycle. Many will continue to be net sellers whilst investment demand for real estate continues to be strong. REITs will also reduce risk further by leasing completed developments whilst occupational markets remain robust and the supply picture continues to be subdued. FINAL THOUGHTS We would encourage investors to look at listed real estate in the same way as direct real estate - taking a long term view to reap the benefits of the asset class and to deliver returns akin to the direct market. Investors with a short-term investment horizon will not get these returns, but something closer to equity in terms of volatility. As with any investment, the opportunities presented by investing in REITs also involve risks relating to share market movements, fundamental real estate asset valuations and currency implications. In the current low-growth environment, the ability to pick those countries and companies that offer the highest growth with the least financial and operational risk provides the opportunity to minimise absolute losses and generate above average relative returns for investors. AMP CAPITAL GLOBAL EQUITIES FORUM 5

6 CHINA IN TRANSITION: ARE YOU EXPLOITING THE OPPORTUNITIES? PATRICK HO Head of Asian Equities CHARLES WONG Head of Asian Listed Real Estate ANDY GARDNER Senior Portfolio Analyst Uncertainty regarding China has been a factor behind global growth worries and sharemarket volatility since mid-last year. In terms of the property sector, we believe that the recent pick up in real estate investment is unlikely to lead to a material improvement to economic growth and we expect this to moderate over the course of the year. This is due to the inventory oversupply in the lower-tier cities and the conflicting objectives of the central government in stimulating growth whilst keep house prices in check. Overall, even though economic growth in China has slowed, that there are some fast-growing sectors that should not be ignored by investors. RAPID RISE OF INNOVATION AND TECHNOLOGICAL CHANGE SHAPES INDUSTRIAL SECTOR Private companies in China are moving further up the value chain through technology. The demand to innovate and the pace of change is staggering. China now has the largest mobile subscriber base, the most expansive 4G network, and one of the most mobile-centric e-commerce platforms in the world. In technology, China has a significant advantage. It can test and learn rapidly, get data off a large sample size of 1.3 billion people, and given a relative lack of concern over privacy, it can build big data sets with more user sensitive information than in the west. Last year, China s ride hailing app Didi Taxi arranged 1.4 billion car rides in China, more than Uber has done worldwide in its history gaining a far greater understanding of consumer behaviour in the process. Almost US$400 billion worth of shopping transactions was conducted on e-commerce giant Alibaba in This represents double the merchandise volume of Amazon.com and ebay combined. Through innovation, China has already increased its market share of higher value manufacturing. China is now recognised as an equal peer for equipment manufacturers and engineering firms in heavy industries, competing with companies such as Caterpillar, Komatsu and Outotec. Most recently, China has successfully produced its own high-end smartphones and motor vehicles, entirely using its own components and software. Chinese smartphone brands (such as Huawei, Lenovo, Meizu and Xiaomi) have increased their global market share from 15% in the fourth quarter of 2013 to 27% in Chinese companies that can demonstrate best-in-class global innovation are likely to experience solid growth. These companies represent a potential competitive threat to companies in developed markets, and investors will need to consider the threads and opportunities in their portfolios of Chinese companies increasing market share in previously uncontested markets. 6 AMP CAPITAL GLOBAL EQUITIES FORUM

7 FINAL THOUGHTS China is still an emerging market so investors need to be cognisant of the volatility; which is much higher than developed markets. For clients with a long-term investment horizon and who can tolerate bouts of short-term volatility, select opportunities in China are compelling. Given that some stock prices fell sharply during the market weakness in the September quarter 2015 and the most recent weakness in January 2016, we believe that investors should side with China s transition and consider allocating to some of China s most dynamic companies in their portfolios. FURTHER READING: China: Disruption within the great rebalance Chinese companies that can demonstrate best-in-class global innovation are likely to experience solid growth. AMP CAPITAL GLOBAL EQUITIES FORUM 7

8 THE INTANGIBLES THAT DRIVE COMPANY VALUE IAN WOODS Head of ESG Investment Research KARIN HALLIDAY Senior Manager Corporate Governance KRISTEN LE MESURIER Senior Analyst ESG The bulk of a company s value is typically, and increasingly, driven by a range of intangible factors. While the specific sustainability drivers and their relative importance will tend to vary from industry to industry, there is a clear correlation between how effectively a company manages them and financial returns. We believe that there are a number of environmental, social and governance (ESG) factors impacting investments. These include the impact of the Paris Climate Change Agreement, gender diversity, CEO pay and some important sustainability drivers that are dramatically changing industries such as the insurance sector in Australia. Investors must look beyond information routinely reported by companies. PARIS CLIMATE CHANGE AGREEMENT The Paris Climate Change Agreement highlights the binding commitment of more than 190 countries (covering Australia, the European Union, Canada, Japan and South Korea) to reduce greenhouse gas emissions by The talks reaffirmed the goal of limiting a global temperature increase by less than 2 C with countries agreeing to regularly report on their own emissions and where possible provide improved targets every five years. The investment implications of the agreement include: > > A more negative outlook for thermal coal miners and oil sands producers and associated rail, port and pipeline infrastructure > > Increasing pressure to retire coal-fired generation globally, and potentially earlier retirement for some than currently planned > > Further subdued increases and potential for decline in electricity demand impacting electricity infrastructure > > Continued favourable policies towards investment in renewables and other low-emission technology > > Underlying support for those involved in light materials and or energy storage such as aluminium businesses and lithium miners With the Paris agreement achieved, the focus for investors is on domestic policy choices and implementation to achieve stated and increasingly stringent emission reduction targets. 8 AMP CAPITAL GLOBAL EQUITIES FORUM

9 GENDER DIVERSITY The business case for improving gender diversity at senior levels of organisations is continually being strengthened as a result of a greater understanding and acceptance of its positive impact on company performance. We ve also found that companies with two or more women directors tend to exhibit better governance, with fewer issues around board composition, the quantum and structure of remuneration, audit integrity and also related-party transactions. This can be attributed to the different perspectives that women bring to the table. When issues are approached from different points of view, it is likely discussions will be more robust and decisions more rewarding. We encourage the companies that we invest in to address roadblocks such as unconscious bias and to cast the net more widely when recruiting. For the pool of talented women to be developed and recognised, there needs to be clear focus on pay parity and the opportunities for women to gain executive experience. We have started to investigate the role of flexible work practices in improving the gender diversity issue. While good progress has been made, there is some way to go before women make up 30% of every Australian board of directors. CEO PAY For some time we have been concerned that the reliance upon global benchmarking studies and comparisons with peers and predecessors has perpetuated a cycle of persistently high levels of pay, irrespective of each executive s specific role and the value they generate. In figure 4, we see that while the average key executive at major Australian companies is paid $1.4 million a year, more than half of all CEOs receive double the amount that the next highest paid executive at their company receives. This implies that, on average, CEOs are considered to be worth twice as much as the second most highly paid executive, who is often the CFO or manager of a significant business division. We believe that executive pay should be structured from a broader perspective - the value that a CEO provides - and that benchmarks and sector comparisons should be one part of the calculation rather than the entire equation. Figure 4: Average total pay for CEOs versus the second highest paid executive $7 Average pay in $A ( millions) $6 $5 $4 $3 $2 $1 $- Consumer discretionary Consumer staples Energy Financials Healthcare Industrials IT Materials Telecommunications services Utilities Source: AMP Capital, as at April 2016 Avg. CEO total pay Avg. next highest paid exec Avg. total KMP pay excl CEO Avg. CEO pay - S&P/ASX200 FINAL THOUGHTS It is a major task to identify the relevant industry-level drivers and then assess how each company manages those drivers. While it can be tempting to focus only on the short-term, investors must look beyond information routinely reported by companies to capture long-term growth, uncover new insights, and realise a competitive advantage. FURTHER READING: Corporate governance report February 2016 Greenhouse gas emissions: Risks and challenges for portfolios CEO pay: What are CEOs worth? Greenhouse gas emissions: Risks and challenges for portfolios AMP CAPITAL GLOBAL EQUITIES FORUM 9

10 CONTACT DETAILS For more information on how AMP Capital can help grow your portfolio, visit our website, Important note: This document is provided for Australian residents and residents of countries where it would not be prohibited or against local laws to provide the information in this document ( Permitted Jurisdictions ). This document is not provided to any person who is a resident of any other country. The information in this document is only available to persons accessing the document from within Australia or another Permitted Jurisdiction. While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN , AFSL ) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital. Copyright 2016 AMP Capital Investors Limited. All rights reserved.